Friday, 8 February 2013

The danger of positive thinking

With global stock markets in the midst of a
major mood swing at the beginning of 2013, a new found optimism brings its own
perils.

It is as if the market
as a whole decided to focus on the positives as its New Year’s resolution. Global stock markets have taken off in
January 2013 as investors have shrugged off the worries that had weighed down on
stock prices in 2012. But while chronic
pessimism has plagued markets over the past few years, the opposite has been the
case in the New Year as stock prices have rebounded to levels which are tough
to justify amid weak growth in the global economy. So even though too much negativity has
wreaked havoc in the markets, unfounded optimism can bring its own problems.

The prices of shares
had been due for a rebound. Investors
had been on a knife edge with the potential for disaster seemingly around every
corner as leaders in Europe dithered during the Eurozone crisis, politicians
stepped up to the edge of the fiscal cliff in the United States, and the
economy in China slowing during changes at the top of the Communist Party. But along with Mayan predictions of the end
of the world, all major catastrophes were averted in 2012 and this prompted a
change of heart after investors returned from their holidays.

Bonds are the typical
haven for investors in times of woe and the past few years followed this
pattern with investors having snapped up the bonds of prudent countries that
have manageable debt levels even though interest rates have been below two
percent. Yet, bond prices have risen so
high that further gains are not likely, but there were few other attractive
investments at the time. And, as 2012 drew to a close, investors aching for
higher returns had already shifted from the safer government bonds into the
bonds of previously shunned countries such as Spain and Italy as well as
corporate bonds.

The new signs of life
in the stock market tempted many into believing that the time was right to take
on more risk and cash in their bonds to place a bet that improvements in the
global economy would pick up pace in 2013.
This scenario has prompted talk of a “great rotation” as a swing in
sentiment prompts investors into moving money from bonds in stocks. The continued printing of money by central
banks to shore up ailing economies has also helped to buoy the spirits of
investors. This all suggests an abundance
of cash which will be heading into the stock market. Yet, although it makes for a nice story to
help prop up share prices, it may just turn out to be a fairy tale.

One of the main
sticking points is that, while share prices have rebounded, the outlook for the
global economy is still grim. Higher
share prices need to be backed up by companies generating larger profits and
this cannot happen until the global economy has regained more vigour. While an economic armageddon has seemingly
been avoided in 2012, growth in the global economy will remain sluggish as high
levels of government debt in many countries are trimmed back over years of
austerity (for more details about Europe in this context, see Both Good and Bad News for Europe).

Despite the holes in
the story of the “great rotation”, many investors have been keen to believe in
a new beginning. Even the temptation of
dubious scenarios can draw buyers back to the market due to concerns about
being left behind if the market rebounds.
Investors also buy on expectations of what will happen in the future
rather than based on the here and now so a dramatic improvement in economic
growth in the following 12 months could prove that now is the right time to
buy. But with many having suffered heavy
losses as share prices plummeted during the global financial crisis, a false
dawn will do little to reassure investors that it is safe to return to the
market. An overly inflated stock market
will also create a conundrum for central bankers and may prompt them to tighten
up monetary policy while the economic recovery is still tenuous. So here’s hoping that investors wake up from
the pipe dream of soaring share prices before it turns into a nightmare.